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SEC Votes to Require Consolidated Audit Trail for Markets

July 12 (Bloomberg) -- The Securities and Exchange
Commission voted yesterday to require exchanges and a broker
oversight group to build a single system to monitor and analyze
trading activity across U.S. equity and options markets.

In a 3-2 vote, the SEC approved a rule requiring the
exchanges and the Financial Industry Regulatory Authority, which
oversees 4,400 brokers, to establish a so-called consolidated
audit trail that will enable the reconstruction of market crises
and expedite surveillance across 13 equity exchanges, 10 options
markets and more than 200 broker-dealers that execute stock
trades away from public venues. The effort is part of the
agency’s response to the May 6, 2010, stock rout that
temporarily erased $862 billion in U.S. equity value.

“A consolidated audit trail that accurately tracks orders
throughout their lifecycle and identifies the broker-dealers
handling them will provide us with an unprecedented ability to
effectively oversee the markets we regulate,” said SEC Chairman
Mary Schapiro. The rule is a “great leap forward,” she said.

The SEC has already implemented circuit breakers to halt
trading when a company’s shares move 10 percent in five minutes
and required market-makers to supply quotes closer to the best
prices than was previously required. Still, Schapiro has pressed
for tools that would allow faster and broader oversight of
trading activity across U.S. venues. After the 2010 market
disruption, a 20-person SEC team needed three months to collect
and process order and transaction data that arrived in different
formats from exchanges and brokers.

Measure’s Strength

Schapiro, a political independent appointed by President
Barack Obama, had to rely on the support of Republican
Commissioners Troy Paredes and Daniel Gallagher to adopt the
rule. The two Democrats on the SEC, Elisse Walter and Luis
Aguilar, opposed the measure, saying it doesn’t go far enough.

Walter said the SEC should have required real-time order
and trade reporting, which exchanges fought as too costly and
unnecessary to meet the agency’s surveillance and enforcement
needs. The rule adopted yesterday would require some of the data
to be reported by 8 a.m. the following day.

“Not striving” for a real-time reporting regime “seems
to ensure that the industry remains one step or one day ahead of
the regulators,” Walter said.

Next-Day Standard

The Securities Industry and Financial Markets Association
had opposed real-time monitoring. The next-day standard adopted
by the SEC “is a more manageable and cost-effective approach to
this kind of system,” Randy Snook, Sifma’s executive vice
president, said in a statement after the vote.

Gregg Berman, a senior adviser to the director of the SEC’s
division of trading and markets, told commissioners at the end
of their meeting that real-time reporting doesn’t provide better
information than the next-day mandate. Data can also only be
used after it’s been checked, orders and trades hailing from the
same source have been linked, and the information has been
aggregated and made available to regulators, he said.

“The only advantage of real-time data is that an analysis
might start sooner but not that it will be better,” Berman
said.

Regulators currently keep tabs on the markets and monitor
trading using data stored in different formats. The consolidated
audit trail would be a centralized data hub that captures order
information throughout the life cycle of a transaction, from
when the buy or sell request is generated to how and when it’s
routed, modified, canceled or executed. Each broker, exchange
and customer would have an identifier that’s reported to the
repository so information can be linked back to the same source.

More Data

The consolidated audit trail will give the SEC’s
enforcement division more data to pursue insider trading and
market manipulation investigations, Steve Cohen, an enforcement
official, said in the meeting. It will also permit the agency to
more easily examine all activity by a trader and not just the
behavior that provoked the investigation, he said.

The lack of access to customer information has hindered and
slowed the division’s investigations, hiding potentially
manipulative activity and forcing the SEC to “cobble together
data from disparate systems, each incomplete, inaccurate,
inaccessible and untimely in their own way,” Cohen said. The
planned audit trail should remedy the problem by enabling the
SEC to identify linked accounts and pursue trading that appears
suspicious more rapidly and confidentially, he said.

Devising Specifics

The SEC’s approval leaves it to the self-regulatory
organizations that operate exchanges and Finra, the private-sector regulator for brokers, to develop the specifics of how
the consolidated audit trail will work in practice. The SEC must
approve the plan before it can be implemented.

“This is an important step that will address cracks in our
fractured market system,” Senator Charles Schumer, a Democrat
from New York, said in an e-mailed statement. “The SEC should
follow through and require high-frequency traders who impose the
highest costs on the system to bear the largest share of the
burden for implementing the consolidated audit trail.”

Regulators will be able to use data collected through the
audit trail to study the strategies of market participants
including high-frequency trading firms and their impact on the
“quality and fairness” of the market, Schapiro said. The
exchanges and Finra must specify how the costs to build and
support the consolidated audit trail will be distributed across
the SROs and their broker-dealer members, according to the SEC.
Many high-frequency traders are brokers.

Plan Deadline

The exchanges and Finra must submit their audit trail plan
within nine months of the rule’s publication in the Federal
Register, according to the SEC. The public will be able to
comment on that plan. If the SEC approves the initiative, the
SROs would begin reporting data to the repository a year after
the plan becomes effective. Bigger brokers would have one more
year before they must report quote and trade data to the
repository while smaller firms would get two years.

While today’s action was a step in the right direction,
it’s “disappointingly weak,” Walter said in the SEC meeting.

“Sometimes the good just isn’t good enough,” she said.
“We appear to be adopting an overly cautious approach.”

The rule should have been more prescriptive and laid out
“minimum requirements” for the accuracy and completeness of
the data, according to Walter. The commissioner also said she
worried the SEC may settle for only “incremental improvements”
to its oversight capabilities if the planned record-keeping
system is built on top of an existing audit trail maintained by
Finra and built a decade ago. “We need far more,” she said.

Finra’s Blueprint

Finra told the SEC last year it could be the technology
processor for the consolidated audit trail. It gave the SEC a
blueprint in April 2011 for a timeline to build the record-keeping system on top of its current order audit trail system,
or OATS. Implementing the system for equities would cost no more
than $125 million, Finra said, not including the expense of
integrating options, bonds, swaps and other products, which the
SEC wants. The exchanges and Finra will be responsible for
selecting the technology provider or plan processor to operate
the repository for the audit trail data, the SEC said in 2010.

“We are not going to throw this rule over the transom and
say to the SROs, ’Come back to us with whatever you think works
here and we’ll be happy to approve it,’” Schapiro said at the
closing of today’s meeting. “We’re going to stay intimately
involved. We’re going to have to push and pull and make sure
that the plan meets our standards.”